Latvia’s Real Estate Market
(Series edited by Dr. Jeff Sommers, affiliated faculty, Stockholm School of Economics in Riga)
Latvia and the World, Global Lessons on Real Estate
By Jeff Sommers
Riga’s prosperity is impressive. Its 10% annual economic growth rates, building boom, and the emergence of a middle class all mark a welcome, and dramatic, departure from the dark days of the 1990s. Yet, booms are accompanied by a burst and when this happens the consequences can be dramatic and unpleasant. Economies run in cycles and post-Soviet Riga is young enough that it has not yet experienced a downturn in its rapidly escalating property market. But, the further that market inflates the greater is danger present of a dramatic rupture that might take the rest of Riga’s prosperity with it.
The sources of Riga’s real estate bubble are complex. The reasons are local, regional, and global. Globally, much of the world is experiencing a property bubble. The US deployed cheap credit to keep up global demand in the wake of the 1997/98 East Asian Crisis. America, and world, was flooded with cheap money. This did restore demand for East Asian goods, thus preventing global economic collapse, but the resulting side benefit was the availability of vast stores of money seeking investment. Given overproduction of goods in China real estate increasingly became the vehicle of choice for investors globally who could not compete with China’s massive reserve army of cheap labor. This option was easier than making money in the real economy of production and technology. Profits were faster and appeared to accrue effortlessly. This was not investment in the economy, but a race to secure capital gains from property price increases.
The alternative source of profits in America by the end the 1990s for investors was still the stock markets. The Dow Jones stock index, starting from the humble figure of 2000 in the year 1982, would rapidly escalate many times over the level of underlying economic growth in the ensuing 18 years. On the cusp of the millennium’s close American pundits declared the US Dow Jones index, then over-inflated and on the cusp of a drop followed by several years of mere catch up in 2006 only to its previous level in 2000 at 11,000, was said to have the potential to rise to 36,000 and even upward to the dizzying heights of 100,000. This wholly unrealistic commentary reflected what was taken for serious discourse in the business press and by stock market enthusiasts. Of course, instead the market plummeted by almost 40% and 6 years later has only reached its previous high, when accounting for inflation, represents a small loss. The NASDAQ tech index was worse yet, losing most its value and only recovering roughly half its worth since in the past 6 years. Investment capital raced into the refuge of real estate in the wake of these stumbling markets. Alan Greenspan, the then US Federal Reserve Chair kept the party going by continuing to pump cheap money into the economy to ensure the good times rolled through to the end of his tenure as Fed Chair. This strategy would have been fine if barriers were built to prevent the money from going to real estate and instead into investment in the real economy of knowledge, technology, and production, but this was not done. Property markets surged on this deluge of cheap American money. Much European real estate boomed too as the Maastricht criteria made the euro expensive and thus European exports less competitive as creation of the euro required low inflation and tight government spending limits driving the value of the euro up, but thus making euro zone exports more expensive on global markets. This process resulted in much capital being reoriented toward real estate. Yet, the results should give us pause, for Japan’s experience reveals the potential problems a real estate bubble might deliver to Latvia’s new prosperity.
Another related factor in the move away from investment in the real economy was US/Japanese competition. In the 1980s the US took the offensive against Japanese manufacturing competitiveness. It first invoked section 301 of US trade law to protect Harley Davidson in the early 1980s against Japanese competition with its then superior motorcycles. With the Plaza accords of 1985 it devalued the dollar against the yen, thus further striking at Japanese competitiveness in the automobile and other sectors. This was at a time when Japanese efficiency was reaching very high levels of automation, yet at enormous investment cost. The response of Japanese capital was to seek higher profits by moving production to its near abroad and into real estate. Both represented flight from quality long-term efficiency in their real economy. The result was the Japanese real estate collapse in 1991 in which Japanese property prices dropped every quarter for over a decade. This had ripple effects into the real economy and created a decade of recession. The Japanese response was to issue credit below cost, in effect giving away money, in an effort to resuscitate their economy. The strategy failed to revive Japan’s economic fortunes, but savvy American investors finally realized the 16th century Spanish search for El Dorado in the form of this practically free money, which they then pumped into US stocks, leading the previously mentioned 1990s stock boom, and subsequent rush on property.
In part Riga’s real estate boom reflects the rise of real estate prices throughout the North Atlantic rim fueled first by Japanese money, then followed by cheap American credit. Riga’s real estate boom began its slow rise in 2000. In part, this represented the flight to real estate as observed in the US and parts of Europe. It also reflected the stability introduced into the Russian economy by Yevgeny Primakov who rescued the economic mess left by Boris Yeltsin and his “reformers.” Primakov was too threatening to Russia’s oligarchs and so had to go after his triage measures stabilized Russia’s economy. Thereafter energy prices rose and Russia was one of the chief beneficiaries. This created regional stability and desire for safe investments for new money. This coincided and worked in symbiosis with Scandinavian and other European investors out for the same as their banks and investors searched for higher and quicker returns than provided from production. This then began a faster acceleration into real estate in 2002.
The net result was a Riga property boom beginning in 2002 that may be outpacing the ability of the underlying economy to support it. The same occurred in Moscow, St. Petersburg, Vilnius, Tallinn and other cities regionally. Those arguing Riga’s real estate can continue its meteoric rise believe the EU 15 and accession country economies will soon fully converge. As incomes rise in the “New Europe,” one would expect their ability to pay higher housing prices. But, Riga’s real estate has risen proportionately much higher than its wealth, or even projected future wealth, can deliver. In this case then it is only foreign money that can sustain the market. There is some possibility that continued oil price rises in Russia and the CIS could further sustain Riga’s property markets further, but even if so, this would lead to Riga’s real estate coming under even further foreign ownership from those sources as they seek investment outlets before the inevitable correction comes. While Latvia surely wants foreign investment, it also does not want to create a property bubble of the type that characterized much of East Asia in 1997. A way to prevent prices from being pushed too high that result in an eventual collapse while retaining responsible growth and securing additional government revenue for social and economic infrastructure would be through adopting a tax plan as advocated by Dr. Michael Hudson.
The reality is that Riga, and Latvia, could face a serious property crash on the horizon that would erase many of the economy’s recent gains, and place at risk its future growth and stability. In the short term, Riga’s property prices will continue their ascent.
This certainly looks like what has happened in other more developed markets before they crashed. It is uncertain whether this dynamic will characterize Latvia’s real estate market. Latvia’s banking regulators are alert to this possibility and will surely try to check any such development. Responsible and competent banking regulation, as Latvia has, along with tax reforms, would be the best way to ensure Latvia’s continued prosperity and avoid the pitfalls of past property bubbles that burst in other parts the world.